While a defined contribution plan may not seem like the most obvious method to raise cash, Employee Stock Ownership Plans (ESOPs) can be an attractive financing source for companies seeking liquidity to make an acquisition. By allowing a company to borrow money and to repay the loan with pre-tax dollars, an ESOP can dramatically improve a company's cash flow and borrowing capacity.
ESOPs are employee benefit plans that invest primarily in the stock of their sponsoring company. Like traditional profit-sharing plans, the sponsoring company makes tax deductible contributions to an ESOP for the benefit of its participating employees. Unlike traditional profit sharing plans, however, ESOPs may borrow to purchase stock from company shareholders or newly issued stock from the company - enabling the company to raise needed capital.
A company may use an ESOP to provide liquidity, diversification or succession planning to its owner, or to finance an acquisition or other capital-intensive objective. The company starts by obtaining an independent valuation of the company so it can determine the fair market value of the stock that is to be sold. It then obtains a bank loan and reloans the proceeds to the ESOP (the "ESOP Loan").
The ESOP, in turn, uses the borrowed funds to purchase company stock, either from existing shareholders ( where the goal is to provide liquidity, diversification, or succession planning to the owner) or a new issuance (where the goal is to provide funds to the company for acquisitions or capital expenditures). These shares are placed in an ESOP trust.
During the tern of the loan - typically a five- or seven- year period - the company makes annual contributions to the ESOP that are equal to the required principal and interest payments. These contributions are tax deductible, within very generous limits. The ESOP then returns the contributions to the company in the form of payments on the ESOP Loan, and the company makes its payments on the Bank Loan. The net effect is that the company's payments on the bank loan - for both principal and interest - are tax deductible. So the government, in effect, finances a portion of the loan.
If an ESOP purchases at least 30% of outstanding securities of a C-corporation, a selling shareholder may elect to defer the gain (referred to as the Section 1042 deferral) so long as the proceeds are reinvested in "qualified replacement property" (basically, the debt or equity of a domestic, operating corporation). Any taxable gain is deferred until the shareholder liquidates the qualified replacement property.
Dividends paid to the ESOP, subject to certain limitations, are also tax deductible as long as they are used to repay ESOP debt or for certain other permitted purposes. For example, a company may issue a new class of stock for the ESOP purchase that is dividend-paying.
As long as the dividend yield reflects market conditions and the dividends are used to repay the loan or for certain other permitted purposes, the dividend payment becomes tax deductible. Normal dividend payments, by contrast, are not deductible for income taxes.
Increased cash flow
Besides their tax advantages, ESOP loans can be more desirable than traditional loans when it comes to cash flow. Assume a company with a taxable income of $500,000 needs to borrow $2 million to finance an acquisition and must pay $300,000 of that annually in loan repayments.
With a traditional loan, the company first pays income taxes of $200,000 (40% of its taxable income), leaving a net income of $300,000. The loan payment of $300,000, however, reduces cash flow to zero.
Besides their tax advantages, ESOP loans can be more desirable than traditional loans when it comes to cash flow.
With an ESOP loan, the $300,000 loan payment is a deductible expense, which reduces taxable income from $500,000 to $200,000. Income taxes are $80,000, leaving a net income of $120,000. Using the ESOP as a financing vehicle, therefore, generates an additional $120,000 of cash flow per year.
Disadvantages of ESOP loans
ESOP loans aren't without their drawbacks. Before adopting this form of financing, it is important to recognize the disadvantages associated with ESOP transactions:
Corporate governance. Newly created ESOP trusts become shareholders in the company, a fact which needs to be considered in light of corporate governance issues. The company founder, who may have historically owned 100% of the stock, now has another shareholder concerned with performance. However, while a minority shareholder has important rights, the majority shareholder retains control in most situations.
Financial disclosure. ERISA requires that company stock held in an ESOP be valued annually to establish participant retirement statements. Additionally, although it is not required, many ESOP companies find it a powerful motivational tool to disclose, basic financial and performance-related statistics to ESOP participants.
Additional administrative costs. ESOP trusts may require the services of independent trustees, the trustees' legal counsel and third-party administrators to oversee the plan. Obtaining required annual stock valuations is an additional cost.
Future liquidity. Eventually, the company must buy back the stock form the accounts of terminated plan participants. This generally doesn't become an issue during the relatively short life of the ESOP loan, but might do so after the loan terminates. However, on the other hand, after the initial ESOP loan has been repaid, the ESOP also provides a ready market for additional stock sales in the future.
Although not for every company, ESOP loans are an alternative method with advantages to selling shareholders, lenders and the company seeking capital. In some cases, ESOPs provide the financing that companies may not otherwise be able to obtain.
Copyright 2004-2005 Trien Rosenberg, Certified Public Accountants and Business Consultants. All Rights Reserved. Reprinted with permission.
About the Author
Trien Rosenberg is a metropolitan area certified public accounting firm with offices in Morristown and New York City. Trien Rosenberg was founded in 1970 with the goal of providing unique and specialized services to our clients. This is achieved by frequent personal contact with each of our clients and our in-depth analysis of their opportunities for growth.
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Trien Rosenberg is a member of the International Group of Accounting Firms (IGAF), a network of accounting and tax firms throughout the world. Our Senior Partner, Jay Trien is Founder and President of both the Venture Association New Jersey, the venture capital networking organization, and the New Media Association of New Jersey. Our partners conduct lender training programs for banks in New York and New Jersey, and we specialize in advising on mergers and acquisitions, capital finance and litigation consulting services. Bill Rosenberg the head of our Tax Department and Jay Trien are both CPAs and tax lawyers. Because of our affiliations and contacts, we can provide clients with access to capital finance and markets throughout the world.